UNIT 5 VALUING RISK MANAGEMENT

Structure

5.0 Objectives

1 5.1 Introduction
5.2 Classical Valuation of Insurance Contracts
5.2.1 Life Insurance
5.2.2 Non-life lnsurance

5.3 Financial Valuation Principles

! 5.3.1 Complete Financial Market
5.3.2 Incomplete Financial Market
5.3.3 Super-replication
5.3.4 Marginal Utility Approach
5.3.5 Quadratic Approaches

5.4 Pricing: Insurance and Finance

5.4.1 Unit-linked Insurance Contracts
5.4.2 Other Insurance Derivatives
5.4.2.1 Catastrophe Insurance (CAT) Futures .
5.4.2.2 Catastrophe-linked Bonds
5.4.2.3 Financial Stop-loss Contracts
5.4.3 Combining Theories for Financial and Actuarial valuation

5.5 Let Us Sum Up

5.6 Key Words

5.7 Some Useful Books and Journals

5.8 Answer or Hints to Check Your Progress

5.0. OBJECTIVES
After going through this unit, you will be able to:

appreciate the methods used for valuation of insurance claims:

see the interplay between finance and insurance in risk valuation; and

understand the methods of valuing unit-linked life insurance contracts

through risk-minimisation
Actuarial Techniques I INTRODUCTION
The actuarial policy combines elements of insurance risk and financial risk to
formulate its risk management. To appreciate the underlying idea, you may
think of schemes such as unit-linked life insurance contracts, catastrophe
insurance futures and bonds, and integrated risk-management solutions.
Therefore, there is a need to understand the developments involving methods
for valuation of risk. Padicularly, we have to appreciate the mechanism
through which the risk in a portfolio of unit-linked life insurance contracts can
be analysed.

Remember that the theory of insurance was formulated mainly to compute the
premiums for life insurance contracts. It was suggested that the methods of
evaluation of life insurance contracts could be carried on combining interest
and mortality. Daniel Bernoulli pointed out that risks should not be measured
by their expectations. He made use of gambling to argue that the preferences of
an individual might depend on her economic situation. Specifically, it could be
quite reasonable for a poorer individual to prefer an uncertain future payment
to another more uncertain payment with a large expected value. On the other
hand, a wealthier person would prefer the payment with the largest expected
value. Recall that we have already seen this argument while studying the
expected utility theory in MEC-01. We have also studied there that individuals
could to buy insurance contracts at a price, which might exceed the expected
value of the payments from the contract.

In order to draw insight from the similar decision making scenario, we may
look at the stock markets. Prices there undergo frequent fludtuations. Such a
feature can be described as a process akin to Brownian motion.

Samuelson (1965) developed a framework where the stock price was modelled
by a geometric Brownian motion i.e., the exponential function of a Brownian
motion. It had the advantage of not generating negative prices. Black and
Scholes (1 973) and Merton (1973) extended this framework with the additional
assumption that money could be deposited on a savings account. Their results
show that options on stocks should be priced such that no sure profits could
arise from composing portfolios of long and short positions in the underlying
stock and in the option itself. Cox, Ross and Rubinstein (1979) showed that the
change in the value of the stock between two trading times could attain two
different values. In that setting, they derived option prices and obtained the
pricing formulae of Black, Scholes and Merton as limiting cases by letting the
length of the time intervals between trading times tend to 0. Building on
concepts and ideas in Harrison and Kreps (1979) for discrete time models,
Harrison and Pliska (1981) gave a mathematical theory for pricing of options
under continuous trading and clarified the role of martingale theory in the
pricing of options and its connection to key concepts such as absence of
arbitrage h d completeness.

The net result of insights thrown by pricing in insurances and finance market in
the presence of risk is the schemes like catastrophe futures and options and
financial stop-loss reinsurance contracts. Thus. the recent methodology of
pricing principles in many insurance products in based on the theories behind
risk and combined approach of insurance and finance.
 Valuing Risk
As you will see we have followed Merller (2001) in developing the present Management
unit. For an easy comprehension same notation as well as sequence of the
above work is retained. In the process we have borrowed freely from it.
Keeping in view the explorative nature of the theme required by the present
course we have discussed the basic ideas contained in Msller (2001). However,
for reference it will be useful to go through the entire work.

To appreciate the tools used for analysing the insurance valuation you should
have understood the stochastic calculus and financial mathematics we have
given in units 3 and 4.

5.2 CLASSICAL VALUATION OF INSURANCE

CONTRACTS
Following the tradition of actuarial theory let us consider life insurance and
non-life insurance separately. Note that there are fundamental differences
between the two areas. For example, in respect of time horizon, the individual
contract for life insurance can extend up to 50 years, whereas for non-life
insurance, it is typically limited to one year. Accordingly, the calculation of
premiums is undertaken differently. We review some notions and key concepts
of life and non-life insurance, placing focus on the valuation techniques used.

5.2.1 Life Insurance

We start with some basic concepts of life insurance. Consider a portfolio of n
lives aged say, y , to be insured at time 0 with i.i.d. remaining life times
iT;,...,T,. Let us assume that there exists a continuous function (called the
hazard rate function) p,,,, such that the survival probability is of the form

A pure endowment contract with sum insured K and term T stipulates that
the amount K , the insurance benefit, is payable at time T contingent on
survival of the policy-holder. Assume that the contract is paid by a single
premium, say, at time 0. Assume further that the seiler of the contract (the
insurance company) invests the premium in some asset, which pays aerate of
return r = ( ) during [o,T] . For the ifh policyholder, the obligation of the
insurance company is given by the present value

J.ld:
H, = llTDrlKeU (2-1)

which is obtained by discounting the amount payable at T , I , ,>, K , using a

rate of return r . Equation (2.1) is a random variable. The fundamental
principle of equivalence states that the premiums should be chosen such that
the present values of premiums and benefits balance on average. If we assume
Actuarial Techniques I in addition that r is stochastically independent of the remaining life times, the
I
principle bf equivalence reduces to

in case of the single premium. This principle is justified due to the law of large
numbers. As the size of the portfolio n is increased, the relative number of 1
n
x
1 "
survivors - = l{,; converges almost surely ( a x ) towards the probability
1-1.

p, of survival to T by the strong law of large numbers since the lifetimes

q ,...,Tnare stochastically independent. Thus, for n sufficiently large, the
actual number of survivors -
1
n
XI,
(,; >,.) will be approximately equal to the

,.
expected number, n p, .

When the amount to be paid to the policyholders is based on a deterministic

rate of return, the principle of equivalence is justified directly by use of the law
of large numbers, which guarantees that the actual number of survivors is close
, to the ,expectednumber.

Rowever, it will be better to consider a more realistic situation by taking the

rate of return ( r ) as a stochastic process. Then the simple accumulating
premium(nk) will not generate the amount to be paid to policyholders since
-6
e
." will differ considerably from its expected value. To deal with this
problem it is necessary to replace the "true" rate of return process r in (2.2)
with some deterministic rate of return process r which is such that the single
premium n accumulated by the true rate of return r is larger than K times the
expected number of survivors with a large probability. The excess (if any)
should then be added to the amount paid to the policy-holder However, this
approach raises the problem of existence of any deterministic and strictly
positive r in a very long time horizon. It has the property that it will be larger
&an the actual return on investments with a very large probability. An
alternative to this approach is therefore to replace r by short rate of interest
and then replace the last term in (2.2) by the price on the financial market of a
financial asset which pays one unit at time T, a zero coupon bond.
1

5.2.2 Non-life Insurance

In the non-life insurance, for premium calculation takes a relatively short time
horizon. For this reason discounting plays a less significant role there. Thus, if
H denotes the claim payable at a time (T), then a premium fi (H) charged is
equal to the expected value E [HI of the claim and we write

The most important examples of such premium calculation principles are:

 -

Valuing Risk
net premium principle or the principle of equivalence A ( H ) = 0 ; Management

expected value principle A ( H ) = a ~ [HI,

standard deviation principle A ( H ) = a ( ~ a r [ ~ ] ) " ' ;

variance principle A ( H ) = a ~ a r [HI ; and

semi-variance principle A ( H ) = aE [ ( ( H - E [ H I ) ' ) ~ ] .

In addition to these, there are some other principles, which we list below:

Fair Premium Principle

Under fair premium principle the calculation aims at a zero increase in

expekted utility. If u is the utility function with u l ( x )2 0 and u " ( x ) 5 0 for
any x E R , and if Vo denotes the insurer's initial capital at time 0,then

That is, the expected utility of the final wealth V, + C ( H )- H from selling the
claim H at thk premium G ( H ) should equal the expected utility of Vo Here
Vo can be interpreted as the wealth associated with not selling the claim H and
th~refore,selling the claim -leaves the expected utility unaffected, i.e., it leads
nd~therto an increase nor a decrease in expectedzltiliEy.
*-

Exponential Principle

In practice use is made of the exponential principle, which is,obtained for the
exponential utility function

In particular, when Vo is constant P -a.s., the solution to (2.5) does not depend
on V, and is given by

Quadratic Utility Function Based Principle

A frequently used utility function' is the quadratic utility function which is

defined by .
Actuarial Techniques I Esscher Principle

The Esscher principle is based on an exponential scaling of the claim (H)such

that

Percentile (Generalised) Principle

The premium calculation principles are sometimes based on the generalisations

of the maximal loss principle. For E E (0, I) and p E [O, I] , the (generalised)
percentile principle states that the premium should be computed as

c(H) = p E [ ~ ] + ( l - p ) ~ - ' ( l - ~ ) ,

where F is the distribution function of H and F-' is its generalised inverse,

i.e., F-' ( y )= inf (XF(X) P y ) . Thus the premium is a weighted average of the
expected value of H and the (1 -&)-percentile of the distribution of H . The
maximal loss principle is obtained when E = 0 and p = 0.

Check Your Progress 1

1) What is fundamental principle of equivalence in insurance?

.........................................................................................

2) How would you formulate the fair premium principle?

 Valuing Risk
3) Write the equations used for exponential principles and Esscher principle.
Management
.........................................................................................

5.3 FINANCIAL VALUATION PRINCIPLES

While developing this section we follow the formulation of Mraller (2001). Let
us discuss some basic concepts of finance theory with a view to see their
implementation in actuarial science. Take a market with two traded assets: a
riskless asset B , some bond (or money market account) and a risky asset (a
stock). Also, take T a fixed finite time horizon and the price processes are
S = (s,),~~, and B = ( B , ) , ~ , ~with
, the underlying probability space defined
on some (a,F,P) . Again introduce the discounted price processes X = S I B
and XO= BIB = 1. To complete the description of the above formulation, let
us specify the information availability at a particular point of time. The agents
have access to information contained in 3 at that point of time t . We also
assume that the stock price is adapted and follows a specific sample path. In
such a setting, we try to see the payoff of a contingent claim from a dynamic
trading strategy. Consider a 2-dimensional process pl = (9,n),<,<, satisfying
certain integrability conditions, where 9 is predictable and q is adapted with
respect to some filtration IF = ( 30)5 r ~ I which describes the evolution of
available information up to time t . The variables in p, = (4,~~) are the
portfolio held at time t . hat is, 9, is the number of shares of the stock held -

at t and t7, ,is the discounted amount invested in the savings account. The'
discounted value at time t of pt is given by ( p )= 9, + q, . The strategy p is .
self-financing if

Let us consider the terms in (3.1). V0( p ) is the amount invested at time 0 and
[S,dX,is thp accumulated trading gains generated up to time t . Thus, for a
self-financing strategy p, the current value of the portfolio p, at time t is
exactly the initially invested amount plus trading gains, so that no in- or out-
flow of capital which has taken place during [ 0 , t ] .Let- H be interpreted as
payoff for some financial contract and investor such as an investment bank
who considers selling a contingent claim, i.e., Rr measurable random
Actuarial Techniques 1 variable H,. Then a contract (or claim) specifying the discounted payoff H at
time T is said to be attainable if there exists a self-financing strategy p such
that V, (p) = H a.s., that is, if H coincides with the terminal value of a self-
financing strategy. Thus, a claim is attainable if and oniy if it can be
represented as a constant H, plus a stochastic integral for the discounted
stock price process

We need the initial investment V, (p) = H , for this perfect replication of H ,

which is called the unique no-arbitrage price of H . To see that any other price
will lead to an arbitrage possibility, i.e., to a risk-free gain, let us suppose that
the price of H at time 0 is .given by H, + E . *here E > 0 . Then risk-free gain
of can be generated as noted by Mialler (2001) in the following way:

Sell the claim H a t time 0 and receive H, + E . Thus, at time T we have to

pay H to the buyer of the claim.

Construct a dynamic hedging strategy by investing Ho through the self-

) taking 9,= 8
financing strategy p = ( 9 , ~ by ; and by choosing 7, such
that (3.1) is satisfied, i.e.,

V, = vo(a)+ j $.a,
- JW, .

The value of the portfolio p, at time T is now exactly equal to H . From

(3.1) and (3.2), we get this condition where the payment is made to the
buyer of the contract,

The net result of all these steps is to find the estimation of gain E from the
trade. If the price of H is Ho + E, with E < 0 , the gain E can be obtained-by
buying H and using the hedging strategy p . We have shswh how the amount
H, received at time 0 can be transformed into the amount H at time T bj.
following a self-ftnancing strategy. There is -np further payment and hence no
more risk. This implies, H, is the fair price.
. ,

5.3.1 Complete Financial Market

A financial market is said to be complete if all claims are attainable. There.are
two models dealing with continuous and discrete time, which can be seefin
this context. 7

Continuous Tim6 Trading: The Black-Scholes model with continuous

trading is an examfie of the complete market. It consists of two assets, a stock
whose price process is described by a geometric Brownian motion and ai
savings account, which pays a deterministic and constant rate of return.

Disrrete Time Trading: We have the COX-ROSS-Rubinstein

(1979) model,
which is called the binomial model. .
In complete market we have no arbitrage possibilities and there is a unique Valuing Risk
Management
risk-neutral measure. A risk-neutral measure is a probability measure Q which
is equivalent to P. The existence of an equivalent martingale measure is
equivalent to the absence of arbitrage opportunities. We have, therefore, the
economic justification for the 'First Fundamental Theorem of Asset Pricing',
given by Harrision and Kreps (1 979).

5.3.2 Incomplete Financial Market

There are some claims, which are not attainable. In other words, these do not
allow a representation of the form (3.2) and hence cannot be replicated by
means of any self-financing trading strategy. Then the market is said to be
incomplete. In this case there are infinitely many risk-neutral measures. In the
discrete time case, incompleteness comes in if we replace the binomial model
with a trinomial model, i.e., a model where the change in the value of the stock
between two trading times can attain three different values. Under continuous
trading, the incompleteness is present if we have a Poisson-driven jump
ccjmponent to the geometric Brownian motion. In the following we list some
different approaches to pricing and hedging.in incomplete markets.

5.3.3 Pricing in Incomplete Market

5.3.3.1 Super-replication
In super-replication we try to find the cheapest self-financing strategy where
the terminal value is no smaller than the payoff of the contingent claim. That
is, for a given contingent claim H , we try to find the smallest number, say,
vO9such that there exists a self-financing strategy

When the price v,* is charged and the strategy @ is adopted, the hedger can
generate an amount, which exceeds the needed amount H , P -a.s.
Consequently a major advantage of this approach is to have no risk to the
hedger. That is, there is no need of additional capital to pay the amount H to
the buyer of the contract after making the initial investment.

5.3.4 Marginal Utility'Approach

Fair prices can also be derived invoking utility functions that describe the
preferences of the buy& and sellers. A marginal utility approach defines the
fair price of a claim H such that one makes investors indifferent between
investing an extra unit of their funds in the contract and not investing in it. In
particular, let u be a utility finction, c the investor's initial capital at time 0,
p the price charged at time 0 per unit of some claim H and z the amount
invested in H . Then,
I
Actuarial Techniques I

where the supremum is taken over all strategies 9 from some suitable space of
processes. The number W ( z ,p, c ) is the maximum obtainable expected utility
for an investor with initial capital cwhen she makes an investment in '
z 1 p units of the risk H . The fair price i2 ( H ;c ) of H is then defined as the
solution 3 to the equation

with the condition that the relevant quantities exist.

5.3.5 Quadratic Approaches

Quadratic methods are applied to pricing and hedging in incomplete markets
with an emphasis on risk minimization. In the process of application we divide
these methods into (i) (local) risk-minimization for X (which is a discount
process and is a martingale) and (ii) mean-variance hedging. In case of the first
approach, X martingale can be generalised to semi martingales. In case of the
second, an attempt is made to approximate the claim H as closely as possible
by the terminal value of a self-financing strategy using a quadratic criterion.
Thus, we try to find a self-financing strategy = ( a o ,q * )which minimises

This strategy is completely determined by the pair (v0 so that the

solution to the problem of minimizing (3.3) is obtained by projecting the
random variable H in L? ( p ). Note that the optimal initial capital V is
,(PO)

called the approximation price for H , and the optimal strategy is the mean-
variance hedging strategy.

Quantile hedging

An important character of the quadratic approach is that it punishes losses and

gains equally. As an alternative to it we use quantile hedging and the objective
is to hedge the claim with a certain probability. Another alternative is the
criterion of minimising the expected shortfall risk, i.e., expected losses from
hedging. In this method a loss hnction 1:[0, a 0 -+ [0, oo) is introduced, which
is taken to be an increasing convex function with l(0 = O ) , and we consider
the problem of minimising
 Valuing Risk
over the self-financing hedging strategies. Usually, loss functiois are power Manage~nt
functions, 1(x) = xP,p 2 1 , and (3.5) is related to minimising the lower partial
moments in such a situation.
*'

Check Your Progress 2

1) Explain the meaning of self-firiancirig principle.

2) What do you mean by complete financial market?

.........................................................
L......... .......................

3) List the pricing principles in incomplete market.

5.4 PRICING: INSURANCE AND FINANCE

We consider some specific areas of the interplay .between finance and
insurance in the following discussion. Before doing that it may be useful to
remember that traditionally finance and insurance have a common tool of
analysis in stochastic processes only. However, increasing collaboration
between insurance companies and banks representing all types of finance in
recent years has made it possible for an interplay between these two fields.
Actuarial Techniques I 5.4.1 Unit-linked Insurance Contracts
A unit-linked life insurance contract differs from the traditional ones. In this
product, benefits depend on the development of some stock index or the value
of some specified portfolio. Such a feature allows for greater flexibility as
compared to the traditional life insurance products as the policyholder is
offered the opportunity of deciding how much of her premiums are to be
invested. We discuss a little more on its features.

Let S, be the value of the stock index at time t . Following the notations used
in M ~ l l e r(2001), we refer to the entire development of the stock as S .
Consider a portfolio consisting of n policyholders with remaining life times
q...q. To simplify the analysis assume that they all buy the same form of unit-
linked pure endowment contract at time 0. Let the life times be stochastically
independent of the development on the financial market. The contracts specify
the payment of some (non-negative) amount f (s)to the policyholder at time
T if she is still alive at this time; the function f describes nature of the
dependence on the development of the stock price. Under such a set up, the
present value at time 0 of the insurance cohpany's liability towards the n
policyholders is given as I

where the payment is discounted by the short rate of interest r . It is possible

that the amount paid could be a function of the terminal value of the stock
only. In that case we have

Another formulation could be to set the terminal value guaranteed against

falling short of some prefixed amount K . Then we have

From (4.2) and (4.3) above we get the contracts which are called pure unit-
linked contracts and (4.3) is called unit-linked with guarantee, the guaranteed
benefit being K . We may extend f to be a more complex function of the
'
process S . For example, we may have a guaranteed annual return

In such a case s,-sj-1 gives the return in year j on the asset S and S, is
s,-I
the guaranteed return in year j . The amount payable at time T is guaranteed at
the time of taking the contract (i.e., at time 0 ) against falling short of
K . n : ( 1 + 8 , ) . However, the guarantee goes beyond this in worst-case
scenario.
 Valuing Risk
'Thus we see that the modern theories of finance offer new valuation principles
Management
and investment strategies for unit-linked insuranse contracts. It combines the
traditional (law of large numbers) arguments from life insurance with the
methods of Black and Scholes (1973) and Merton (1973). In the process we
could (i) replace the uncertainty of the insured lives by their expected values,
(ii) include the actual insurance claims by taking into account mortality risk as
well as financial risk. Such modified claims have contained financial
uncertainty only. Thus, instead of considering the claim (4.1), this method
examines

,
where the notation p,= P(T, > T) . Such modified claims can be treated as
options, with a long maturity period. As a result, these could be priced and
hedged using the basic principles of Black and Scholes (1973) and Merton
(1 973).
Let us look at the insurance related results of unit-link4 contracts:
In case of pure unit-linked contract (4.2), the claim (4.4) is proportional to the
terminal value of the stock ST and hence can be hedged by a buy-and-hold
strategy which consists in buying n,py units of the stock at time 0 and holding
these until time T .
Case of no guarantee
When there is no guarantee, the unique no-arbitrage price of H' is simply
!
I n,p,s,. Thus, you can prescribe one possible fair premium for each
I policyholder is ,-pysOwith the probability of survival to T times the value at
time 0 of the stock index.
Case of contract with benefit
i Write f (s)= max(S,, K ) = (S, - K)' +K and consider the pricing of a
Ii
European call option. Then from (4.4) it follows that the premium is r + p y ~ f ,
1 where v,' is the price at time 0 of the purely financial contract which pays
f ( S ) at time T

1 5.4.2 Other Insurance Derivatives

There are products known as insurance derivatives which combine financial

ii derivatives and insurance products. These have the features of traditional

insurance risk and financial derivatives. For example, consider reinsurance
valuation such as catastrophe futures, catastrophe-linked bonds, financial stop-
loss contracts and stop-loss contracts with a barrier.

5.4.2.1 Catastrophe Insurance (CAT) Futures

I Occurrence of several catastrophes of large magnitude in 1980s and 1990s

I impaired the capacity of reinsurers offering traditional catastrophe covers. As a

result, there was a move to increase the reinsurance premiums. In 1992 the
Actuarial Techniques I catastrophe insurance (CAT) futures and options on CAT futures were
introduced. These instruments standardised catastrophe insurance risk and
transformed these into tradeable securities, providing a new tool for insurers
seeking cover against catastrophe risk.

5.4.2.2 Catastrophe-Linked Bonds

Individual insurance companies can choose to securitise part of their insurance

risk directly. For example, they may issue bonds that are linked to insurance
losses from certain insurance portfolios. One example of such an arrangement
is the Winterthur Insurance Convertible Bond, also called WinCAT bond ( ~ e e
Merller (2001) for greater discussion). This bond was introduced by Winterthur
in 1997. Under this scheme, investors receive annual coupons as long as
certain catastrophic events related to one of Winterthur's own insurance
portfolios have not occurred. Thus, the investors receive a return from the bond
whiCh exceeds the market interest rate as long as no catastrophe has occurred
and a lower return in the case of a catastrophe. The difference between the
return under no catastrophe and the interest rate on the market was essentially a
premium that Winterthur paid investors for putting their money at risk.
Similarly, the low return in connection with a catastrophic event implied that
the investors had covered part of Winterthur's losses.

5.4.2.3 Financial Stop-loss Contracts

We have seen that CAT futures and Catastrophe-linked bonds are aimed at a
larger group of investors. The reinsurance contracts in these combine elements
of insurance and financial derivatives. There are some new contracts described
by 'Integrated Risk Management Solutions'. One example init is financial
stop-loss contract. It pays at some fixed time T the amount

where U,. is the aggregate 'claim amount during [0, TI on some insurance
portfolio, YT is some financial loss and K is some retention limit. The
financial stop-loss contracts cover large losses due to fluctuations within the
insurance portfolio (insurance risk) and adverse development of the financial
markets (financial risk). Reinsurance companies would be able to sell spreads
on the form

where 0 I K, IK, ,which covers the (K,, K,] layer of the losses U , + YT.

The insurance contract (4.5) helps provide cover for the insurer's total risk, i.e.,
the oornbined insurance risk from the insurance portfolio and the financial risk
from the financial portfolio. With a traditional stop-loss contract, the reinsurer
would cover insurance losses exceeding the level K . However, the financial
stop-loss contract is designed so that the cover is only psid provided that the
insurance loss augmented by the financial loss exceeds this level. Thus, a large
financial gain - YT may compensate for large insurance losses, and in this
situation, the buyer does not really need additional compensation from the
reinsurer.
 Valuing Risk
5.4.3 Combining Theories for Financial and Actuarial Management
Valuation
Consider the basic difference between financial valuation techniques, (more
precisely, pricing by no-arbitrage) and the classical actuarial valuation
principles reviewed above. We have seen that the financial valuation
are formulated within a framework which includes the possibility of trading
certain assets. In contrast to these the classical actuarial valuation principles
are based on considerations involving the law of large numbers. In addition,
the financial valuation principles are based on dynamic trading, whereas many
decision problems in insurance are traditionally analysed taking a static view.

Dynamic Reinsurance Markets

The dynamic reinsurance markets in a continuous time framework using no-

arbitrage conditions can be analysed. This is possible as some of the processes
related to an insurance risk process are tradeable.

From Actuarial to Financial Valuation Principles

Gerber and Shiu (1996) among others have examined the situation where the
logarithm of the stock price process is a Levy process, i.e., a process with
independent and stationary increments. Within this setting, they demonstrate
how the Esscher transform (2.6) can be used in the pricing of options. They
also give a very simple option pricing formula which involves Esscher
transforms and which, for a European call option, specialises to the Black-
Scholes formula in the case of a geometric Brownian motion. Moreover, they
also demonstrate how this pricing formula can be derived through a simple
1-a
x
utility indifference argument in the case of power utility function u ( x ) = -
1-a
with parameter a > 0 .

In Schweizer (2001), the starting points are the traditional standard deviation
and variance principles, which are of the form (2.4). These principles are taken
as measures of riskiness, which assign to each claim a premium. It is then
argued that the measures can equivalently be viewed as measures of
preferences which operate on the insurer's terminal wealth by simply changing
the sign on the loading factor.

Check Your Progress 3

1) Which technique of finance will you use for insurance pricing?

Actuarial Techniques I 2) How the modern theories of finance offer new valuation principles for
unit-linked insurance?

3) Which insurance derivations combine financial derivatives and insurance

products?

4) Which actuarial concepts are relevant to be used for solving financial

markets problems?

5.5 LET US SUM UP

In this unit we have discussed the methods used for hedging and valuing
insurance claim with financial risk. An attempt is made to focus on pricing
rules that make an investor indifferent between investment in insurance and
finance. In the process we have addressed the important themes that bring out
the interdependency between insurance and finance. We have dealt with the
application of financial pricing techniques to insurance problems. Following
the similar logic, the actuarial concepts that are reference to finance problems
are pointed out.
 Valuing Risk
KEY WORDS Management

Actuarial Equivalent: An alternative form of a benefit equal in value. For

example, a Lump Sum payout of a benefit rather than smaller monthly
payments.

Actuarial Valuation: In an actuary of a pension or a benefit plan trust, this is

tbe total amount needed to meet promised benefits. This set of mathematical
procedures typically calculates the value of benefits to be paid, the funds
available, the annual contribution required, and the amount of expense that an
organization can take on for accounting and tax purposes.

I
4
Complete market : A market is complete with respect to a trading strategy if
there exists a self-financing trading strategy such that at any time t, the returns
r of the two strategies are equal. That is, all cash flows for a trading strategy can
t be replicated by a similar synthetic trading strategy. Because a trading strategy
can be simplified into a set of simple contingent claims ( a trading strategy that
pays 1 in one state and zero in every other state ), a complete market can be
generalized as the ability to replicate c ~ flows h of all simple contingent
claims.

Contingent Claims: Assets or securities whose prices depend on the values of

other assets or numerical indices.

Financial Market : A mechanism which allows people to trade money for

securities.

Financial Risk : Any risk associated with money.

Hazard Function : By calculating the failure rate for smaller and smaller
intervals of time At, the interval becomes infinitesimally small. This results in
the hazard function, which is the instantaneous failure rate at any point in
time:

~(t)-~(t+~t)
h(t) = lim
+.o At.R(t)

Failure Distribution: Continuous failure rate depends on a failure

distribution, F(t), which is a cumulative distribution function that describes
the probability of failure prior to time t,

~(tst)=~(t)=i-~(t),t>o.

Failure Distribution Function: The failure distribution function is the

integral of the failure density function ,Ax),

~ ( t=) If ( x ) m .

The hazard function can be defined as

-4ctuarial Techniques I

Degenerate Function: A variable taking a certain value so as to be considered

nonrandoa. But it satisfies the definition of random vaiable. This is useful
because it puts deterministic variables and random variables in the same
format.

Hedge : An investment made to reduce the risk in another investment.

Hedging: A strategy designed to minimise exposure to an unwanted business

risk, while still allowing the business to profit from an investment activity.

Law of Large Numbers: An outcome with repeated, independent trials with

the same probability of success in each trial where the percentage of successes
is increasirigly likely to be close to the chance of success as the number of
trials incredses.

Self-Financing: A strategy when a company is able to release liquidity in

order to finance operating charges and development. It is equal to the net profit
to which .you reintegrate all the entries that are not associated with the
movements of cash such as depreciation and provisions, appreciation and
depreciation of asset disposals.

Unit-linked Insurance: The premium is invested in units of a unitised

insurance hnd. Units are encashed to cover the cost of the life assurance.

Market Risk - the potential to experience financial losses due to fluctuations

in the prices at which equities, foreign currencies, interest rate linked
securities, and commodities can be bought or sold.

SOME USEFUL BOOKS AND JOURNALS

\

Msller, Thomas (2001), On Valuation and Risk Management Finance,

Laboratory of Actuarial Mathematics, University of Copenhagen (see internet)

Embrechts, Paul, Riidige Freg, Hansis & Furren (1999), Stochastic Process in
Insurance and Finance, ETH ziirich, Switzerland (see internet)

Black, F. and Scholes, M. (1973), The Pricing of Options and Corporate .

Liabilities, Journal of Political Economy 8 1,637-654

Cox, J., Ross, S, and Rubinstein, M. (1979), Option Pricing: A Simplified

Approach, Journal of Financial Economics 7, 229-263

Gerber, H.0. and Shiu, E. S. W. (1996), Actuarial Bridges to Dynamic

Hedging and option Pricing, Insurance: Mathematics and Economics 18, 183-
218

Harrison, J. M. and Kreps, D. M. (1979), Martingales and Arbitrage in Multi-

period Securities Markets, Journal of Economics Theory 20, 38 1-408
 Valuing Risk
Harrison, J. M. and Pliska, S. R. (1981), Martingales and Stochastic Integrals Management
in the Theory of Continuous Trading, Stochastic Processes and their
Applications 11 , 215-260
i Hull, J. C. (1997), Options, Futures, and &her Derivations, International
i Edition, Prentice-Hall

Merton, R. C. (1973), Theory of Rational Option Pricing, Bell Journal of

Economics and Management Science 4,14 1- 183

Samuelson, P. A. (1965), Rational Theory of Warrant Pricing, Industrial

Management Review 6, 13-31

Schweizer, M. (2001), From Actuarial to Financial Valuation Principles,

Insurance: Mathematics and Economics 28,3 1-47

5.8 ANSWER OR HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1

1) See Sub-section 5.2.1 and answer.

I 2.) See Sub-section 5.2.2 and answer. '

3) See Sub-section 5.2.2 and answer.

Check Your Progress 2

+
1) See Section 5.3 and answer.

2) See Sub-section 5.3.1' and answer.

3) See Sub-section 5.3.3 and answer.

Check Your Progress 3

1) See Section 5.4 and answer.

t

! 2) See Sub-section 5.4.1 and answer.

1 3) See Sub-section 5.4.2 and answer.

1 4) See Sub-section 5.4.3 and answer.